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This morning the Nikkei index has dropped has much as 6%. By any measure this is an extreme drop in stock prices in one day. Furthermore, we are now officially in bear market territory as the Nikkei is down more than 20% in just three weeks. I can only see one reason for this and one reason only and that is the breakdown of the credibility of Bank of Japan governor Kuroda and his commitment to fulfill his official 2% inflation target.

I would particularly highlight three events for this breakdown of credibility.

First of all I would stress that it seems like the Japanese government has been taken by surprise by the natural increase in bond yields and that is causing officials to question the course of monetary policy. This is Economy Minister Akira Amari commenting on the increase in bond yields on May 19:

“We need to enhance the credibility of government bonds to prevent a rise in long-term yields.”

This at least indirectly indicates that some Japanese government officials are questioning what the BoJ has been doing and given the highly political nature of the Japanese monetary policy setting these comments effectively could make investors question the direction of monetary policy in Japan.

Second the Minutes from Bank of Japan’s Policy board meeting on April 27 released On May 26 and comments following this week’s monetary policy meeting.

“Regarding the effects of JGB purchases on liquidity in the JGB and repo market, a few members … expressed the opinion that it should continue to deliberate on measures to prevent a decline in liquidity”

Said in another way some BoJ board members would like the BoJ to try to keep bond yields from rising – hence responding to Mr. Amari’s fears. There is fundamentally only one way of doing this – abandoning the commitment to hit 2% inflation in two years. You can simply not have both – higher inflation and at the same time no increase in bond yields. Bond yields in Japan have been rising exactly because Mr. Kuroda has been successful in initially pushing up inflation expectations. It is that simple.

And third, at the BoJ’s monetary policy announcement this week Bank of Japan governor Kuroda failed to clarify the position of the BoJ and that undoubtedly has unnerved investors further.

Hence, it is important that market turmoil does not reflect a fear of higher nominal bond yields on its own, but rather whether higher bond yields will cause the BoJ to abandon the commitment to increase inflation to 2%.

Therefore what is happening is a completely rational reaction from investors that rightly or wrongly fear that the BoJ is changing course.

As I again and again has stressed Mr. Kuroda can end the market turmoil by first of all stating that the increase nominal bond yields is no worry at all (particularly as real bond yields actually have dropped sharply) and furthermore he should clearly state that the BoJ’s focus is on inflation expectations. Hence, he should state that the BoJ effectively is ‘pegging’ market (breakeven) inflation expectations to 2%. If he did that he would effectively have hindered inflation expectations dropping over the past three weeks. The drop in Japanese inflation expectations in my view is the main cause of the turmoil in global financial markets over the past three weeks.

Should we give Mr. Kuroda a break?

I might be too harsh to Mr. Kuroda here. After all should we really expect everything to be ‘perfect’ at this early stage in the change to the monetary policy regime Japan after 15 years of failure?

“Lars, give it some time. The regime change at the BOJ is still very new and the ideological shifts in old conservative institutions, with long traditions, such as the BOJ take some time. I think Kuroda made it implicitly clear enough that higher nominal rates are ok as long as real interest rates slump/stay low.”

I think Mikio (who like a lot of market participants, central bankers and monetary policy nerds have join the Global Monetary Policy Network on Linkedin) is on to something here.

We are seeing a revolution at the BoJ so one should not really be surprised that it is not all smoothing sailing. However, on the other hand I am personally very doubtful where we are going next. Will Kuroda effectively be forced by events to abondon his commitment to 2% inflation or will he reaffirm that by becoming much more clear in his communication (don’t worry about higher nominal bond yields and communicate clearly in terms of inflation expectations).

I have my hopes, but I don’t know the answer to this question, but one thing seems clear and that is that nearly everything in the global financial markets – from the value of the South Africa rand, commodity prices and the sentiment in the US stock markets – these days dependent on what Mr. Kuroda does next. Don’t tell me that monetary policy is not important…

PS David Glasner is puzzled by what is going on the US financial markets. I think I just gave the answer above. It is not really Bernanke, but rather Mr. Kuroda David should focus on. At least this time around.

When I started this blog I set out to write about monetary policy issues – primarily from a none-US perspective – and furthermore I am on vacation with my family in Malaysia so writing this blog post goes against everything I should do – however, after listen to five minutes of debate about the ”fiscal cliff” on CNBC tonight I simply have to write this: What is your problem? Why are you so scared about fiscal consolidation? After all this is what the fiscal cliff is – a 4-5% improvement of public finances as share of GDP.

The point is that the US government is running clearly excessive public deficits and the public debt has grown far too large so isn’t fiscal tightening exactly what you need? I think it is and the fiscal cliff ensures that. Yes, I agree tax hikes are unfortunate from a supply side perspective, but cool down a bit – it is going to have only a marginally negative impact on the long-term US growth perspective that the Bush tax cuts expiries. But more importantly the fiscal cliff would mean cuts in US defense spending. The US is spending more on military hardware than any other country in the world. It seems to me that US policy makers have not realized that the Cold War is over. You don’t need to spend 5% of GDP on bombs. In fact I believe that if the entire 4-5% fiscal consolidation were done, as cuts to US defense spending the world would probably be a better place. But that is not my choice – and it is the peace-loving libertarian rather than the economist speaking (here is a humorous take on the sad story of war). What I am saying is that the world is not coming to an end if the US defense budget is cut marginally. Paradoxically US conservatives this time around are against budget consolidation. Sad – but true.

Since September the Federal Reserve has had the Bernanke-Evans rule in place. That means basically means that the Fed will step up monetary easing in response to any increase in unemployment. Hence, if the full fiscal cliff leads to any increase in unemployment the fed will counteract that with monetary easing. So effectively the fiscal cliff means fiscal tightening and monetary easing. This of course would also be the case if the fed was a strict inflation targeting central bank – that directly follows from the Sumner critique.

Fiscal consolidation and monetary easing is this is exactly what the US had in 1990s – the best period for the US economy since WWII. By at that time a Democrat President also had to work with a Republican dominated Congress.

So no, I don’t understand what there is to fear. Lower public spending and easier monetary policy is the right medine for the US economy (yes and please throw in some structural reforms as well). If that is the fiscal cliff please bring it on. It will be good for America and good for the world. And it might even be a more peaceful world.

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PS if you are really concerned about the fiscal cliff just agree on this:

1) Cut US defense spending to 2% of GDP

2) NO tax hikes

3) Commit the fed to bring back NGDP to the pre-crisis trend level through QE

Update: My version (second and third!) version of this post had an incredible amount of typos – sorry for that. I have now cleaned it up a bit.

Update 2: David Glasner also comments on the fiscal issue – David agrees with me in theory, but is more worried about the what the fed will do in the real world. When David is saying something I always listen. David is a real voice of reason – often also of moderation. That said, I strongly believe the Sumner Critique is correct. NGDP is determined by monetary policy and not by fiscal policy – so if the fiscal cliff will lead to a recession the fed will be to blame and not the US politicians (they are to blame for a lot of other things…).

Arthur Laffer’s recent piece in the Wall Street Journal on fiscal stimulus has generated quite a stir in the blogosphere – with mostly Keynesians and Market Monetarists coming out and pointing to the blatant mistakes in Laffer’s piece. I on my part I was particularly appalled by the fact that Laffer said Estonia, Finland, Slovakia and Ireland had particularly Keynesian policies in 2008. In my previous post I went through why I think Laffer’s “analysis” is completely wrong, however, I did not go into details why Laffer got the numbers wrong. I do not plan to go through all Laffer’s mistakes, but instead I will zoom in on Estonian fiscal policy since 2006 to do some justice to the fiscal consolidation implemented by the Estonian government in 2009-10.

In his WSJ article Laffer claims that the Estonian government has pursued fiscal stimulus in response to the crisis. Nothing of course could be further from the truth. One major problem with Laffer’s numbers is that he is using public spending as share of GDP to analyze the magnitude of change in fiscal policy. However, for a given level of public spending in euro (the currency today in Estonia) a drop in nominal GDP will naturally lead to an increase in public spending as share of GDP. This is obviously not fiscal stimulus. Instead it makes more sense to look at the level of public spending adjusted for inflation and this is exactly what I have done in the graph below. I also plot Estonian GDP growth in the graph. The data is yearly data and the source is IMF.

Lets start out by looking at pre-crisis public spending. In the years just ahead of the escalation of the crisis after the collapse of Lehman Brother in the autumn of 2008 public spending grew quite strongly – and hence fiscal policy was strongly expansionary. I at the time I was a vocal critique of the Estonian’s government fiscal policies.

There is certainly reason to be critical of the conduct of fiscal policy in Estonia in the boom-years 2005-8, but it does not in anyway explain what happened in 2008. Laffer looks at changes in fiscal policy from 2007 to 2009. The problem with this obviously that he is not looking at the right period. He is looking at the period while the Estonian economy was still growing strongly. Hence, while the Estonian economy already started slowing in 2007 it was not before the autumn of 2008 that the crisis really hit. Therefore, the first full crisis year was 2009 and it was in 2009 we got the first crisis budget.

So what happened in 2009? Inflation adjusted public spending dropped! This is what makes Estonia unique. The Estonian government did NOT implement Keynesian policies rather it did the opposite. It cut spending. This is clear from the graph (the blue line). It is also clear from the graph that the Estonian government introduced further austerity measures and cut public spending further in 2010. This is of course what Laffer calls “fiscal stimulus”. All other economists in the world would call it fiscal consolidation or fiscal tightening and it is surely not something that Keynesians like Paul Krugman would recommend. On the other hand I think the Estonian government deserves credit for its brave fiscal consolidation. The Estonian government estimates that the size of fiscal consolidation from 2008 to 2010 amounts to around 17% (!) of GDP. I think this estimate is more or less right – hardly Krugmanian policies.

And maybe it is here Laffer should have started his analysis. The Estonian government did the opposite of what Keynesians would have recommend and what happened? Growth picked up! I would not claim that that had much to do with the fiscal consolidation, but at least it is hard to argue based on the data that the fiscal consolidation had a massively negative impact on GDP growth. Laffer would have known that had he actually taken care to have proper look at the data rather than just fitting the data to his story.

Laffer of course could also have told the story about the years 2011 and 2012, where the Estonian government in fact did introduce (moderate) fiscal stimulus. And what was the result? Well, growth slowed! The result Laffer was looking for! Again he missed that story. I would of course not claim that fiscal policy caused GDP growth to slow in 20011-12, but at least it is an indication that fiscal stimulus will not necessary give a boost to growth.

PPS If you really want to know what have driven Estonian growth – then you should have a look at the ECB. Both the boom and the bust was caused by the ECB. It is that simple – fiscal policy did not play the role claimed by Laffer or Krugman. It is all monetary and I might do post at that at a later stage.

The weekend’s Greek elections brought a neo-nazi party (“Golden Dawn”) into the Greek parliament. The outcome of the Greek elections made me think about the German parliament elections in July 1932 which gave a stunning victory to Hitler’s nazi party. The Communist Party and other extreme leftist also did well in the Greek elections as they did in Germany in 1932. I am tempted to say that fascism is always and everywhere a monetary phenomenon. At least that was the case in Germany in 1932 as it is today in Greece. And as in 1932 central bankers does not seem to realise the connection between monetary strangulation and the rise of extremist political forces.

The rise of Hitler in 1932 was to a large extent a result of the deflationary policies of the German Reichbank under the leadership of the notorious Hjalmar Schacht who later served in Hitler’s government as Economics Ministers.

Schacht was both a hero and a villain. He successfully ended the 1923 German hyperinflation, but he also was a staunch supporter of the gold standard which lead to massive German deflation that laid the foundation for Hitler’s rise to power. After Hitler’s rise to power Schacht helped implement draconian policies, which effectively turned Germany into a planned economy that lead to the suffering of millions of Germans and he was instrumental in bringing in policies to support Hitler’s rearmament policies. However, he also played a (minor) role in the German resistance movement to Hitler.

The good and bad legacy of Hjalmar Schacht is a reminder that central bankers can do good and bad, but also that central bankers very seldom will admit when they make mistakes. This is what Matthew Yglesias in a blog post from last year called the Perverse Reputational Incentives In Central Banking.

Here is Matt:

I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard … and part of what’s so incredible about it are that Schacht’s two great achievements—the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation—were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.

To step back to the hyperinflation. You might ask yourself how things could possibly have gotten that bad. And the answer really just comes down to refusal to admit that a mistake had been made. To halt the inflation, the Reichsbank would have to stop printing money. But once the inflation had gotten too high for Reichsbank President Rudolf Havenstein to stop printing money and stop the inflation would be an implicit admission that the whole thing had been his fault in the first place and he should have done it earlier…

…So things continued for several years until a new government brought Schacht on as a sort of currency czar. Schacht stopped the private issuance of money, launched a new land-backed currency and simply . . . refused to print too much of it. The problem was solved both very quickly and very easily…

…The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.

Matt is of course very right. Central banks and central banks alone determines inflation, deflation, the price level and nominal GDP. Therefore central banks are responsible if we get hyperinflation, debt-deflation or a massive drop in nominal GDP. However, central bankers seem to think that they are only in control of these factors when they are “on track”, but once the nominal variables move “off track” then it is the mistake of speculators, labour unions or irresponsible politicians. Just think of how Fed chief Arthur Burns kept demanding wage and price controls in the early 1970s to curb inflationary pressures he created himself by excessive money issuance. The credo seems to be that central bankers are never to blame.

Here is today’s German central bank governor Jens Weidmann in comment in today’s edition of the Financial Times:

Contrary to widespread belief, monetary policy is not a panacea and central banks’ firepower is not unlimited, especially not in the monetary union. First, to protect their independence central banks in the eurozone face clear constraints to the risks they are allowed to take.

…Second, unconditional further easing would ignore the lessons learned from the financial crisis.

This crisis is exceptional in scale and scope and extraordinary times do call for extraordinary measures. But we have to make sure that by putting out the fire now, we are not unwittingly preparing the ground for the next one. The medicine of a near-zero interest rate policy combined with large-scale intervention in financial markets does not come without side effects – which are all the more severe, the longer the drug is administered.

I don’t feel like commenting more on Weidmann’s comments (you can pretty well guess what I think…), but I do note that German long-term bond yields today have inch down further and is now at record low levels. Normally long-term bond yields and NGDP growth tend to move more or less in sync – so with German government 10-year bond yields at 1.5% we can safely say that the markets are not exactly afraid of inflation. Or said in another way, if ECB deliver 2% inflation in line with its inflation target over the coming decade then you will be loosing 1/2% every year by holding German government bonds. This is not exactly an indication that we are about to repeat the mistakes of the Reichbank in 1923, but rather an indication that we are in the process of repeating the mistakes of 1932. The Greek election is sad testimony to that.

PS David Glasner comments also comments on Jens Weidmann. He is not holding back…

PPS Scott Sumner today compares the newly elected French president Francois Hollande with Léon Blum. I have been having been thinking the same thing. Léon Blum served as French Prime Minister from June 1936 to June 1937. Blum of course gave up the gold standard in 1936 and allowed a 25% devaluation of the French franc. While most of Blum’s economic policies were grossly misguided the devaluation of the franc nonetheless did the job – the French economy started a gradual recovery. Unfortunately at that time the gold standard had already destroyed Europe’s economy and the next thing that followed was World War II. I wonder if central bankers ever study history…They might want to start with Adam Tooze’s Wages of Destruction.

David Glasner is a very nice and friendly person, but I have to admit that David always scares me a bit – especially when I disagree with him. For some reason when David is saying something I am inclined to agree with him even if I think he is wrong. There are two areas where David and I see things differently. One the “hot potato” theory of money and two our view of Milton Friedman. I tend to think that the way Nick Rowe – inspired by Leland Yeager – describes the monetary disequilibrium theory make a lot of sense. David disagrees with Nick. Similiarly I have an (irrational?) love of Milton Friedman so I tend to think he is right about everything. David on the other hand is much more skeptical about Friedman.

Now David has post in which he makes the argument that Friedman nearly had the same view as James Tobin on the hot potato theory of money – which of course is stark opposition to Nick’s view. So now I have a problem – if he is right I must either betray uncle Milt or revise my view of the hot potato theory of money. Ok, that is not entirely correct, but you get the drift.

Anyway I don’t have a lot of time to write a long post and David’s discussion is much more interesting than what I can come up with. So have a look for yourself here.

I will be traveling quite a bit in the coming weeks so I am not sure how much blogging I will have time for. I will be in Riga, Stockholm, London, Dublin, Moscow and New York in the next couple of weeks so I might run into some of my local readers.

PS David sent me Tobin’s article long ago and I must admit that I have not read it carefully enough to be able to argue strongly for or against it.

A couple of days ago I noted that Josh Barro had a good understanding of US monetary policy and the causes of the Great Recession. In my post I wondered whether Josh also would favour NGDP level targeting.

He is Josh’s “answer”:

I would prefer to see the Federal Reserve adopt a rule, such as NGDP level targeting, that would lay out an orderly path for monetary easing in recessions and tightening upon recovery. But I don’t think we need to worry about the Federal Reserve losing its grip on any ad-hoc decisions to allow some moderate inflation. It’s just not in this Fed’s nature—and the markets know it.

The quote above is from an article today in on the Forbes website where he discusses Amity Shlaes’ very odd claim that Milton Friedman would have been against QE in the US over the last couple of years. I don’t want to go into that discussion (I will simply become too upset…). Let me instead quote Josh:

The Cleveland Fed inflation estimates, based on financial market data including the interest rate spread between ordinary and inflation-protected Treasury bonds, show expected inflation of 1.4 percent per year over the next ten years. So, if Shlaes knows about an inflation bomb that the young guns on Wall Street can’t see, she has the opportunity to go make a ton of money in the bond markets.

Inflation isn’t nearly as mysterious as Shlaes makes it out to be. Milton Friedman is on point here: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” If inflation starts to get out of control, all the Fed has to do is contract the money supply.

The Fed is sure to have to do this in the medium term. The housing crash, banking crisis and recession caused a sharp drop in the velocity of money. MV = PQ, so the Fed had to greatly expand the monetary base in order to prevent deflation. As the velocity of money picks up, the Fed will need to contract the monetary base to prevent rapid inflation.

If it’s this simple, why do countries ever have undesirably high inflation? Sometimes, as with Zimbabwe, it’s because they’re printing money as a fiscal strategy. At other times, as in the U.S. in the 1970s, there is insufficient political will for the sometimes-painful step of monetary contraction.

The former is not a serious fear in the United States. As for the latter, it is possible to imagine a central bank that lacks the discipline to tighten when appropriate. But not this Federal Reserve, which has a strong bias toward disinflation and many of whose members seem to have had to be dragged, kicking and screaming, into the insufficient amount of easing we have had to date.

Josh is obviously completely right and I hope that he in the future will continue to participate in the debate concerning US monetary policy and continue to advocate NGDP level targeting.

PS David Glasner also has a comment on Amity Shlaes’ claims concerning QE and Milton Friedman – HEALTH WARNING! My friend David is moderately critical of Friedman in his comment – despite of this we are still friends;-)

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be. If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

“I had just started getting interested in Austrian economics – while my contemporaries were experimenting with drugs, I was experimenting with Austrian economics; go figure! I sure hope no permanent damage was done”

I have now been blogging since early October last year and I truly enjoy it. Most of my readers seem to be happy about what I write and I believe that most of my readers and commentators are quite Market Monetarist sympathies. However, there is one exception – lefty blogger Mike Sax. Yes, I called him lefty – I don’t think Mike would not disagree with this (if he called me a libertarian that would not make me angry either…). Mike is actually reading the Market Monetarist blogs and I think he pretty much understands what we are talking about. I will readily acknowledge that despite the fact that I probably disagree with 99% of what he has to say about economics and monetary theory.

Today I ran into a comment Mike wrote a couple a days ago about the debate about fiscal policy between on the one side the New Keynesian (Old Keynesians??) and on the other side the Market Monetarists (and John Cochrane). Even though Mike is extremely critical of my views I actually had quite a lot of fun reading it.

Here is Mike Sax (and yes, believe it or not the name of his blog is “Diary of a Republican Hater”…):

“If you want to get the endgame of this whole market monetarist phenomenon I say put down Scott Sumner and check out Lars Christensen. His post is called simply Market Monetarist, and indeed the very name of market monetarism is actually his coinage rather than Scott.

During the interminable tangent-a rather amusing three ring circus that Sumner led-Lars wrote a post called “There is no such thing as fiscal policy.” This is a pretty radical attack on fiscal policy. From Cochrane claiming that fiscal policy can’t work-till his bout face today-and Sumner saying it can never be as effective as monetary policy in reviving demand-we have Lars claiming it simply doesn’t exist.

Whoa! I guess if it doesn’t even exist we can’t use it. Ever. It’s another postmodernist mind fuck evidently. What are Cochrane and Christensen going to say to each other now? I will suggest that if you want to make any sense of market monetarism read Lars. You get it much more concisely and to the point if nothing else.

Now here is his point. In a barter economy, he tells us, there can be no fiscal stimulus. Why is this? Because, “As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand.”

Fiscal policy can redistribute income but not effect demand.

“in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”

Ok but maybe the title of this post is wrong. It shouldn’t say there is no such thing as fiscal policy just fiscal stimulus.

The reason we believe that fiscal policy can impact demand is because of money illusion.

“for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.”

What NGDP targeting is meant to do is to take away money illusion by taking away this misleading effect of the velocity of money.

“Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.”

The goal of NGDP targeting therefore as Sumner, Lars, David Glasner, et al, conceive it is a return to in effect a barter economy. Money is therefore for them kind of like the root of all evil or at least original sin. Like for old fashioned philosophers appearance was the veil that led us to misapprehend true existence, so for the market monetarists, money is the veil that makes us misapprehend the truth of the economy.

Yet Lars does admit that fiscal stimulus can work or seem to work due the the Circe of money.

“lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.”

Yeah let’s say that. Actually I think this accurately describes the actual historical record of the Fed between the time of Marriner Eccles and the 1970 when Milton Friedman started whispering sweet nothings in Nixon’s ear.

To be sure Christensen claims that this effect is still misleading as it’s the printed money-monetary policy-that does the real heavy lifting. It would have been exactly the same had the supply of money been increased and government spending been kept constant.

In a way these claims by Lars actually straddles the line with MMTers who do actually argue that it makes no difference whether the Fed or Treasury prints the money but where they go from here is obviously more or less diametrically opposed to what the MMers do with it. The Market Monetarists vs. The Modern Monetary Theorists… Talk about a battle royale.

Again though Lars should call this “There is no such thing as fiscal stimulus.” It seems to me though that even if you believe that fiscal stimulus is a fiction it may nevertheless have proved to be as the belief in God once was.

For what’s curious is during the time we believed fiscal stimulus we had the Keynesian era. Since we gave it up we have had an anti-Keynesian era. During this anti-K ear we have seen the wages of median Americans stagnate. Is this all coincidence? What do you think?

In any case Sumner’s oft repeated argument that the fiscal multiplier is roughly zero because any fiscal stimulus will be followed by monetary tightening according to Lars depends on the policy of the Fed. It wasn’t true during the Keynesian ear. However in this anti inflation era, post Volcker and of the Taylor Rule-the much lauded Great Moderation-it is true of how the Fed has in fact acted. This doesn’t prove that fiscal stimulus doesn’t work but rather the Fed is off the rails and probably could use the kind of reforms Barney Frank wanted for it. Namely not ending the Fed as Ron Paul says but rather ending its “independence.””

Frankly speaking, Mike of course have no clue about economics, but he is 100% right – I should of course have said that there is no such thing as fiscal stimulus (and not policy), but then he would have had nothing to write about. Mike don’t know this, but I hate everything “postmodernist” so he succeed with his low blow.

Anyway, let me say it again fiscal policy is not important. People like Paul Krugman (and Mike Sax) think that we need massive fiscal stimulus to take us out of the slump in Europe and the US and some think (for example European policy makers) think that the only solution is fiscal austerity. I think both parties are wrong – lets fix monetary policy and then we don’t have to worry (too much) about fiscal policy (other than balancing the government budgets in the medium to long run…). This is why I find it so utterly borrowing to discuss fiscal policy…

PS Mike mentions Battle Royal…he is unaware that that is my favourite Japanese movie.

It can be rather traumatic for children to see their parents fight. I feel a bit like that when I see two of my heroes Scott Sumner and David Glasner discuss fiscal policy. The whole thing started with Scott picking a fight with a couple of Keynesians. To be frank that discussion really didn’t turn me on and even though I read most of what Scott writes this was not a discussion that I was particularly interested in. And it is certainly not my plan to address what the discussion really is about – let me just say I think Scott makes it unusually complicated – even though I think he is right (I guess…). Instead I will try to explain my view of fiscal policy or rather to explain why I think there really is no such thing as fiscal policy – at least not in the sense that Keynesians talk about it.

In an earlier post – “How I would like to teach Econ 101” – I have explained that there seems to be a disconnect between how economists think about microeconomics and macroeconomics. I think this disconnect basically also creates the misunderstanding among Keynesians about what fiscal policy is and what it can do.

The way we normally think of microeconomics is an Arrow-Debreu world with no money. Hence, we have a barter economy. As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand. Furthermore, it is not possible, as public expenditures in barter economy basically have to be funded by “forced labour”. “Taxes” will be goods that somebody is asked to “pay” to government and government “spend” these “revenues” by giving away these goods to other people. Hence, in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”.

Therefore for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.

Lets start out with the standard Keynesian stuff:

(1) Y=C+I+G+X-M

Where Y is GDP (nominal GDP!), C is private consumption, I is investment, G is government expenditure, X is imports and M is imports. There is nothing wrong with this equation. It is an identity so that is no up for discussion.

Lets make it a little simpler. We assume that we have a closed economy so X=M=0. Furthermore lets assume that we define “private demand” as D=C+I and lets write nominal GDP as P*Y (Keynesians assume the P=1). Then we get the following equation:

(1)’ P*Y=D+G

In the barter economy P*Y is basically fixed hence it must follow that an increase in G must lead to a similar decrease in D. There is full crowding out.

So lets introduce money with another identity – the equation of exchange:

(2) M*V=P*Y

Combining (1)’ and (2) with the following:

(3) M*V=D+G

This basically explains why Scott keeps on talking about monetary policy rules when he discusses fiscal policy. (By the way this is a very simple IS-LM model).

Hence, the impact of fiscal policy on nominal GDP/aggregate demand crucially dependents on what happens to M and V when we increase G.

Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.

However, lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.

There, however, is one more possibility and it is that a change in G in someway impacts money-velocity (V). This is what happens in the traditional IS-LM model. Here an increase in G increases “the” interest rate. As the interest rate increases the demand for “bonds” increases and the demand for money drops. This is the same as an increase in V. This model in my view is rather ridicules for a whole lot of reason and I really should not waste people’s time on it, but lets just say that the whole argument breaks down if we introduce more than the two assets – money and “bonds” (Google Brunner and Meltzer…). Furthermore, lets say that we are in a small open economy where the interest rate is given from abroad then changes in G will not influence the interest rate (as least not directly) and hence fail to impact V. If the interest rate is determined by inflation expectations (or NGDP expectations) then the model also breaks down.

But anyway lets assume that this is how the world works. But lets also assume that the central bank has a NGDP level target. Then the increase in G will lead to a drop in money demand via a higher interest rate and thereby to an increase in V. However, as the central bank targets a fixed level for NGDP (M*V) an increase in V will have to be counteracted by an “automatic” drop in M. So again the monetary policy reaction function is crucial. In that sense it is also rather tragic that we had a long debate during the 1970s between old style Monetarists and Keynesians about the size of the interest rate elasticity of investments and money demand with out having any discussion about how this was influenced by the monetary policy rules. (This is not entire true, but bare with me).

One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.

That said, fiscal policy of course can have an impact of the supply side of the economy and that is ultimately much more important – especially as the ill (lack of aggregate demand) the Keynesians would like to cure cease to exist if the central bank targets the NGDP level.

——

PS don’t expect me to write a lot more about fiscal policy. The idea that fiscal policy can be used to “stimulate” aggregate demand is just too 1970s for me. Even New Keynesians had given up on that idea during the “Great Moderation”, but some of them now seem to think it is a great idea. It is not. And no this is not some “Calvinist” idea I have – I just don’t think it will work.

UPDATE: Scott continues the fiscal debate (lets stop it Scott, we won long ago…)

UPDATE 2: Sorry for the typos…trying to write fast – sitting in Warsaw airport waiting to board on my flight back home to Copenhagen.

UPDATE 3: Back home with my fantastic family in Denmark – while my family is now asleep I see that Scott has yet another fiscal policy comment.

UPDATE 4: Nick Rowe sketch a very similar model to mine. Apparently Danish and Canadian monetarists think alike.